With Both Bonds and Stocks Declining, What’s a Smart Investor to Do?

By Moe Zulfiqar | Small Business

With Both Bonds and Stocks Declining, What’s a Smart Investor to Do?Starting near the end of 2012 and then going into 2013, there was a significant amount of noise around the concept of the “Great Rotation.”

The idea behind this concept is that low yields on U.S. bonds would cause investors to sell their bonds positions, which would eventually bring bond prices down, driving investors toward stocks. That would send the key stock indices higher.

Now, since the Federal Reserve announced that it might be pulling back on its quantitative easing, the concept of the Great Rotation seems to be gaining some traction once again. And investors are asking if it’s really going to happen.

Looking at the chart below of 10-year U.S. bond yields, it’s very clear that investors don’t like the U.S. bonds—they are selling. The yields on 10-year U.S. bonds have skyrocketed; they are now more than 44% higher than they were at their lowest level in August 2012.

With Both Bonds and Stocks Declining, What’s a Smart Investor to Do?

Chart courtesy of www.StockCharts.com

According to TrimTabs, an investment research company, through to June 24, investors sold $61.7 billion worth of bond mutual funds and exchange-traded funds (ETFs). While this may not sound big, this is the highest sell-off since October 2008, when investors sold $41.8 billion worth of mutual funds and ETFs. (Source: Bhaktavatsalam, S.V., “U.S. Bond Funds Have Record $61.7 Billion in Redemptions,” Bloomberg, June 26, 2013.)

Now that we see investors fleeing the bonds market, shouldn’t they go to the stock market, thereby causing the markets to climb higher?

Yes, according to the concept of the Great Rotation, the key stock indices should be climbing higher. Sadly, the reality is the opposite: as the bond prices have declined, the key stock indices have done the same.

Since the announcement by the Federal Reserve, the S&P 500, for example, is down roughly two percent. Look at the chart below and pay close attention to the circled area. If the Great Rotation were in play, then we would have seen the key stock indices soar as the bond prices declined:

With Both Bonds and Stocks Declining, What’s a Smart Investor to Do?

Chart courtesy of www.StockCharts.com

So what should a smart investor do? Sell everything, or just pick between the bonds or the stocks and wait and see what happens?

When it comes to portfolio management, one concept investors must embrace is the need to reduce their risk on a constant basis. The truth is that the bond market is witnessing a significant amount of negative pressure, and the market may continue to go lower as the losses of investors who recently bought bonds start to run higher. If investors are heavily exposed in the bond market, their portfolio will become a victim—reducing exposure to the bond market will save them from a little misery.

As I have said many times before, the markets are always changing. Investors need to adjust the allocation of their portfolios; what worked five years ago may not be successful now.